Investments having potential for large returns often involve some element of risk. Many approaches have been used to hedge against or otherwise manage risk associated with such investments. One well known way to reduce such risk is through the diversification of investments. In theory, diversification of investments applies the law of averages in order to reduce risk from multiple independent sources.
Many times, however, it is possible to hedge against a first position, such as a market commitment to a tradable asset, for example, by undertaking a second position that may share some common risk factors or elements with the first. In doing so, investors may be presented with different options to hedge against the risk associated with a given position. For instance, an individual interested in investing in a particular stock may be unwilling to bear potential losses beyond a particular level. Since the price of the stock could drop at any time to undesirable levels, such an investment inherently carries an element of risk. To hedge against such risk, the investor may purchase both the stock and a put option. The put option gives the investor the right to sell the stock at a fixed exercise, or strike, price up until a given expiration date. If the stock price drops below the strike price, the investor may execute the put option and profit the difference between the exercise price of the put option and the market price of the stock at the time the put option is executed. In this manner, the investor may protect himself against the risk (and the associated losses) that the stock will decrease in price below the strike price of the put option. Thus, it can be seen that an investor may hedge risk by combining a buy position on a security with the right to exercise a contrary sell position on that same security.
Not only do hedged positions decrease risk, they can be used to ensure a sale that will substantially limit losses. For example, an investor may purchase a stock and sell a call option giving the option buyer the right to buy the stock at an exercise price by a given date. Suppose a pension fund holds 1,000 shares of stock with a current price of $55 per share and intends to sell all 1,000 shares if the stock price reaches $60 per share. By selling $5 calls on all 1,000 shares, each having an exercise price of $60, the fund can make $5,000 in revenues. If the stock price falls, the call options will not be executed and thus the fund's losses due to the fallen stock price will be mitigated by the $5,000 revenues from the sale of the call options. If the stock price rises above $60 (say, to $70 per share) and the call options are exercised, the fund has not lost any potential profits since the fund originally intended to sell its shares at $60 per share anyway.
The examples provided above illustrate how different positions may be combined to hedge against risk and/or create profit opportunities. However, in order to engage in such trades, traders must be well-informed about market conditions to anticipate such opportunities, and must also be able and willing to undertake such commitments. In addition, in order to obtain a particular level of risk protection or profit margin, significant capital and firm commitments are often required, as well as various transaction costs, margin requirements and/or credit and credibility checks.